Banks' dark off-balance-sheet world

By Bill Fleckenstein

With all of the problems that we have experienced thus far in structured credit, one might think that there would be more people scratching their heads about why there are so many off-balance-sheet entities in the financial community in the first place.

I wish I had a good answer. It's pretty obvious that little attention had been paid to these entities, at least from the perspective of potential problems.

Daylight: Enemy of chicanery

Of course, the fact that conduits, and special-purpose entities generically, reside off balance sheets is a reason why everyone has been caught by surprise. Because if mountains of this paper are away from plain sight, potential problems can't be anticipated, as you can't attempt to understand what you can't see.

For instance, Jim Grant of Grant's Interest Rate Observerreports that in the most recent 200-page annual report to the Securities and Exchange Commission from State Street (STT, news, msgs), only three paragraphs are devoted to the commercial-paper conduit that has caused it so much grief recently.

In any case, with the spotlight now trained on the structured-credit arena, institutional investors have become choosier about what paper they're willing to own, thus creating the illiquid environment that the short-term money-market funds and the banks currently find themselves in.

For the banks, this comes at an inconvenient time because they're trying to figure out how to deal with the $300 billion-plus of leveraged buyouts they've committed to finance. Conduits tend to roll at the same time. And last week was one of those occasions when a considerable amount -- more than $100 billion -- of asset-backed commercial paper needed to be rolled, meaning that the debt required refinancing.

Centauri, dorada, yada yada yada

Meanwhile, though London appears to be the epicenter of conduit angst these days, our homegrown Citigroup (C, news, msgs) appears to have plenty of exposure. That's according to a friend who in an e-mail to me rattled off the following list of its structured investment vehicles, or SIVs: Beta Finance, Centauri, Dorada, Five Finance, Sedna Finance, Vetra Finance and Zela Finance. He was able to obtain a portfolio commentary for Beta Finance, in whose summary I found three interesting items.

First of all, for those folks who can't quite wrap their arms around what an SIV, an SPIV (special-purpose investment vehicle) or a conduit is, those names all stand for pretty much the same thing: special-purpose entities that reside off balance sheets. Think of them as virtual savings and loans that can be quite sizable. There are no real rules that govern what they can buy. And because they're off balance sheets, they operate with little regulation.

Citigroup notes that the leverage in this particular vehicle, Beta Finance, is "only 14.24 times." Thus, Citigroup, a leveraged entity, owns a gaggle of leveraged S&Ls. That helps illustrate a point I've made many times: that the well of liquidity that bulls were citing two months ago as a reason to be bullish was just a wall of leverage. (It's worth noting that the net asset value of Beta Finance has declined 19% from its high and that Citigroup's other conduits are apparently down a similar amount.)

What lives beyond the adjectives?

Next, Citigroup says: "We highlight that all U.S. CMBS exposure is supersenior." What I find interesting in that comment: The company has taken pains to note that its CMBS, or commercial mortgage-backed paper, carries the highest rating -- implying that there might be a problem with lesser-rated tranches of commercial mortgaged-backed paper.

That echoes a data point provided by someone wishing to remain anonymous who resides near the top of the lending food chain at one of the world's largest banks. The source indicated to me that commercial mortgage-backed securities will also see problems. Though I did not get the impression from her that the timing was imminent, the weakness in the commercial version of the ABX index indicates that some pain is already being dispensed, even if little ink has been spilled on this subject.

Singing an ode to opacity

It just boggles the mind how much leverage is employed by financial institutions and how little knowledge the world has of their workings.

As to why these infinitely leveraged black boxes (with extremely flexible accounting and disclosure rules) exist in the first place, I think we know the pat answer: so that financial institutions can employ them and utilize even more leverage than they are legally allowed to.

Which makes one wonder: Since these entities are designed specifically to circumvent the rules, why have they been countenanced by the rule makers?

At the time of publication, Bill Fleckenstein did not own or control shares of any of the securities mentioned in this column.